Is Goldilocks Going to End Soon?

Darius sat down with Mike Ippolito last week on the On The Margin podcast to discuss the FOMC, interest rates, inflation, and more.

If you missed the interview, here are three takeaways from the conversation that have significant implications for your portfolio:

1. We Believe The Projections From The September FOMC Meeting Are Wishful Thinking

In the September FOMC meeting, the FED hiked its 2024 and 2025 median dot plot estimates by 50 basis points.

The Fed raised its median Real GDP estimates by more than double for 2023 to 2.1% and by 40bps for 2024 to 1.5%.
The Fed lowered its median unemployment rate estimate by -30bps to 3.8% for 2023, -40bps to 4.1% for 2024-25, and sees unemployment at 4.0% in 2026.

Despite these hawkish revisions to its growth and labor market estimates, the Fed still sees Core PCE decelerating by 3.7% by year-end, 2.6% by 2024, 2.3% by 2025, and 2.0% by 2026.

We disagree with the Fed’s projections and believe they will need to engineer a recession to bring down inflation to below-trend levels.

2. The Fed Will Likely Need to Cut Rates More Than What The Market Is Currently Pricing

The current Fed Funds futures pricing shows the expectation that the Fed will begin cutting rates mid-2024 – we believe this current pricing is misguided.

Our research shows that a recession is the modal outcome, so we believe the Fed will need to cut by more than what is currently priced.

The 10-year three-month treasury yield curve, an indicator that has successfully predicted a recession eight out of the nine times it has inverted since its inception – and eight of the last eight – continues to be deeply inverted and supports our view.

3. Inflation Will Likely Trend Higher In The Coming Months

Our research shows that the median Core PCE delta in the year leading up to a recession is +5 bps, suggesting Core PCE is generally ‘flat to up’ in the year preceding a recession.

Additionally, the three-month annualized rates of the different indicators of the inflation basket have halted their downward trend. Although the headline YoY numbers may continue to decelerate, we are seeing increases in specific indicators like:

Energy inflation increased to 25.4% on a three-month annualized basis after spending approximately one year compounding negatively.
Core PPI Less Food Energy and Trade Services increased to 3.3% on a three-month annualized rate in August.

We believe that many of the indicators that make up the inflation basket will trend higher in the next few months and will not decline to below-trend levels until we go through a recession.

That’s a wrap!

If you found this blog post helpful:

Go to www.42macro.com to unlock actionable, hedge-fund-caliber investment insights.
RT this thread and follow @DariusDale42 and @42Macro.
Have a great day!

The Current State of China

Darius sat down with Anthony Pompliano last week to discuss China’s economic landscape.

If you missed the interview, here are three takeaways from the conversation that have significant implications for your portfolio:

1. The Evergrande Debt Default May Have Spillover Effects on The Broader Chinese Economy

One of Evergrande’s subsidiaries recently defaulted on nearly 600 million dollars worth of principal and interest payments.

The implications are significant for two reasons:

Evergrande has 328 billion of debt outstanding, the largest of any property developer in the world.
Evergrande will be in court next month to discuss a potential liquidation.

A bankruptcy of Evergrande’s size could lead to knock-on effects for the Chinese economy.

2. If China Does Not Issue Large-Scale Fiscal Stimulus, They Will Likely Remain In Their Liquidity Trap.

China and Japan supplied trillions of dollars in global liquidity from Q4 2022 to Q1 2023, a primary factor in the BTC and stock market recovery we have seen so far this year.

But if China does not issue large-scale fiscal stimulus, they will likely fall back into their “liquidity trap”:

For the last decade, Chinese growth has been below trend, with the exception of early 2021.
China has also struggled to generate inflation.

Today, China’s economy looks very similar to Japan’s from the early 1990s.

3. Just Because The Chinese Economy Has Downshifted From A Growth Perspective Does Not Mean It Will Stop Demanding Energy Products

The volume of Crude Oil imports is near all-time high levels established in 2020.

Conversely, the volume of Copper imports is down 38% from the 2020 highs.

This is significant because Crude Oil creates inflation across the global economy, while Copper more closely signifies underlying demand for materials and goods and is correlated to growth.

That’s a wrap!

If you found this blog post helpful:

Go to www.42macro.com to unlock actionable, hedge-fund-caliber investment insights.
RT this thread and follow @DariusDale42 and @42Macro.
Have a great day!

What is the Outlook for Commercial Real Estate?

Darius recently sat down with Nick Halaris to explore the current state of US commercial real estate.

If you missed the interview, here are three takeaways from the conversation that have significant implications for your portfolio:

1. A Commercial Real Estate Disaster May Be On The Horizon

Over the past couple of years, there has been a confluence of factors that have negatively impacted the real estate sector:

The rise of interest rates
The blow-up in Crypto
The increase in layoffs at tech companies
Office space occupancies leveling off at 50%
The regional banking crisis

As a result, US commercial property prices are back down to pre-covid levels. Although they have declined substantially since the COVID-19 blow-off top, they will likely decline even further.

2. Commercial Real Estate Distress Levels Are On The Rise… Albeit Slowly

Distress levels in US commercial real estate have been accelerating since mid-2020 but are not yet at levels seen in the Great Financial Crisis because:

Banks learned from the Great Financial Crisis that the rapid withdrawal of liquidity from real estate would hurt them, so they are more patient with borrowers and more lenient with covenants.
The “Goldilocks” economy continues to be resilient, supporting the real estate sector.

3. Commercial Real Estate Investment Volume Is Drying Up

Investment volume is down significantly YoY across commercial real estate:

Multifamily: -70%
Industrial: -48%
Office: -63%
Retail: -65%

Sellers are hesitant to sell because they expect inflation will increase again, increasing the value of their properties back to 2022 levels.

Buyers are hesitant to buy because their existing exposure is declining in value and interest rates are pricing them out of further investment.

Transactions are sparse as a result. The waiting game continues….

That’s a wrap!

If you found this blog post helpful:

Go to www.42macro.com to unlock actionable, hedge-fund-caliber investment insights.
RT this thread and follow @DariusDale42 and @42Macro.
Have a great day!

Will Inflation Come Back HOT?

Darius recently sat down with Anthony Pompliano to discuss inflation, its direction, and its effect on asset markets.

If you missed the interview, here are three takeaways from the conversation that have significant implications for your portfolio:

1. Headline CPI Is Accelerating Again, Primarily Due to Energy

Last month, the 3-month annualized growth rate of headline inflation spiked from just under 2% to 3.9%.

A material increase in energy inflation drove the move.

Until last month, the three-month annualized rate of energy inflation had been negative for approximately one year; the August CPI report indicated an energy inflation increase of 25.4% on a 3-month annualized basis.

We expect the increase in energy inflation to persist as Brent crude oil continues its upward momentum.

2. Core CPI Continues to Decelerate, Primarily Due to Shelter

While Headline CPI is increasing, Core CPI, a measure that excludes some of the most volatile components like food and energy prices and therefore provides a clearer view of the underlying trend in inflation, is decreasing.

Last Wednesday’s report showed that:

Core CPI decelerated to 2.4% on a 3-month annualized basis – the lowest reading since 2021.
Core Goods CPI inflected negative to -1.9% on a 3-month annualized basis.
Shelter Inflation materially impacted Core CPI as it declined from just over 5% to 4.4% on a 3-month annualized basis.

3. Producer Price Inflation Is Back on The Rise Again And May Also Represent The Vanguard of Sticky Inflation

PPI, which measures price changes from the producer’s perspective, accelerated to 4.2% on a 3-month annualized basis – the highest value since the first half of last year.

Leading underlying measures of inflation like Super Core PPI are beginning to show upside momentum and we are starting to see the first signs that inflation is potentially bottoming out.

The return of inflation is negative for asset markets – with it comes a stronger dollar and greater bond market volatility, both of which are headwinds for any increase in global liquidity.

That’s a wrap!

If you found this blog post helpful:

Go to www.42macro.com to unlock actionable, hedge-fund-caliber investment insights.
RT this thread and follow @42Macro and @42MacroWeather.
Have a great day!

US-Global Growth Divergence

Last week, Composite PMIs came in below expectations across continental Europe and in China. Stagflation is the fear in Europe, while deflation is the fear in China. Neither public sector appears ready to supply the liquidity required to ignite animal spirits within their respective economies and financial markets. Regarding the Composite PMI data specifically, only four (Japan, Russia, Brazil, and US) of the 13 economies that have reported thus far posted MoM accelerations in August. Only Japan, China, India, Russia, Brazil, and the US reported figures greater than 50, indicating expansion. Europe was a noteworthy laggard with Spain, Italy, France, Germany, Eurozone, and UK all slowing sequentially to sub-50 readings, indicating contraction.

It is now fashionable to make the short-USA/long-RoW (rest of world) call, citing valuation differentials, but we disagree with that view. Valuation is not a catalyst for market developments, Rather, valuation merely acts as an accelerant when flows reverse. FWIW, we do not believe valuations matter all the time; in fact, most of the time valuation is irrelevant because the overwhelming majority of investors cannot take risk in accordance the time horizons (3, 5, 10 years) that valuation metrics are most instructive on. Retail investors generally operate on short to medium-term time horizons because of FEAR and FOMO; institutional investors generally operate on short to medium-term time horizons because of career risk.

“No Landing” = No Liquidity, Says The US Dollar

The US Dollar Index is poised for its ninth consecutive weekly advance — the longest winning streak since 2005 as the global currency market rerates economic resiliency in the US and derates the economic outlooks in Europe and China. The reason why FX and interest rate volatility are drags on global liquidity is because when net international investment surplus economies like Japan and the Eurozone see their currencies weaken, it makes it harder for their financial intermediaries to create the dollars required to capitalize investments around the world. FX and interest rate volatility complicate that process and slow down the creation of new dollar supply at the margins.

Growth of the world’s demand for dollars is more stable due to the refinancing requirements of the existing stock of cross-border financing that is denominated in USD — roughly 50% of the total, with ~65% of cross-border loans and ~80% of international debt securities issued by entities that have no organic access to dollars. Thus, fluctuations in the supply of new dollars have an outsized influence in driving FX trends because of the relatively inelastic demand for dollars versus a more elastic dollar supply curve. More FX and interest rate volatility = marginal dollar supply falls faster than marginal dollar demand = stronger dollar. Less FX and interest rate volatility = marginal dollar supply rises faster than marginal dollar demand = weaker USD. This process is reflexive and feeds on itself until exogenous factors like central bank pivots inflect the trend. This is why price momentum in the currency market tends to trend.

Buy The Dip Until “Immaculate Disinflation” Transitions To “Sticky Inflation”

A return of inflation pressure destroys the “transitory GOLDILOCKS” narrative and potentially derails the actual GOLDILOCKS US economy that has supported risk assets for the past few quarters, paving the way for a cross-asset crash. Our qualitative research views expect that process to occur within 3-6 months. Our best guess based on the momentum in key inflation time series and the labor market is sometime around yearend or early in the new year.

Emphasis on “guess”. We deliberately never speak in certainties about the future; the only investors that do are those chasing clout on podcasts and social media platforms. Beware conviction from folks that lack the DEEP, DAILY Bayesian inference process required to understand the full distribution of probable economic and financial market outcomes.

If we are wrong on the timing of the handoff from “immaculate disinflation” to “sticky inflation” and it happens much sooner than our 3-6 months [from now] projection, our Global Macro Risk Matrix will transition from risk-on REFLATION to risk-off INFLATION early in that process. Such a shift would be your queue to shift from a buy-the-dip mentality to a sell-the-rip mentality in asset markets. It would also be your queue to pivot defensively from a factor tilt perspective. Until then, we remain constructive on risk in accordance with the “transitory GOLDILOCKS” that we co-authored with our friend Bob Elliott in January.

The US Economy Remains As Resilient As Ever

Last week’s +1.8pt MoM advance in the ISM Services PMI (54.5 = 6mo high) was adequately presaged by the New York Fed’s Services Survey a couple of weeks ago. The New Orders PMI hit a 6mo high as well alongside the highest reading in the Employment PMI since Nov-21.

The probability of a near-term recession continues to dwindle because the services sector accounts for 86% of Total Nonfarm Payrolls.

Offsetting the positivity was the 4mo high in the Prices PMI, which is now trending higher again. If the inflation narrative devolves sooner than our qualitative research views anticipate, we could be in the early innings of a market crash.

China’s Crude Oil Imports accelerated to 30.9% YoY in August, fanning the flames of an ill-timed, hazardous breakout in energy prices.

All eyes on Wednesday’s August CPI report to confirm or disconfirm the prevailing “immaculate disinflation” theme, which itself is one-half of the “transitory GOLDILOCKS” theme we co-authored in mid-January (with the other being “resilient US economy”).

Will Bitcoin Crash Before The Halving?

Darius recently sat down with Anthony Pompliano to discuss global liquidity, bitcoin, the Fed, and more.

If you missed the interview, here are three takeaways from the conversation that have significant implications for your portfolio:

1. The Years Leading Up to Bitcoin Halvings Are Extremely Volatile.

When we analyzed the past Bitcoin halvings from November 2012, July 2016, and May 2020, we found that in the years leading up to the halving, Bitcoin tends to have three drawdowns of more than -20% on a median basis.

All drawdowns in the year leading up to halvings have a median decline of -27%.

We believe Bitcoin will be much higher in a few years, but it will likely require a rough path to reach its destination.

2. Over The Next Year, Liquidity Will Determine Bitcoin’s Path.

On a median basis, Bitcoin increases 144% in the year leading up to halvings.

These increases have closely followed global liquidity cycles; the liquidity cycle bottomed in 2012 and 2015, years leading into the halvings where Bitcoin increased 384% and 144%, respectively.

However, in 2019, when liquidity conditions were less favorable than in 2011 and 2015, Bitcoin failed to see a similar price increase.

The increase that year was only 20%, and the drawdowns were more significant than in the previous pre-halving years.

The amount of liquidity in asset markets will decide Bitcoin’s path over the next year.

3. We Believe The Fed Will Be Forced to Increase Their Inflation Target From 2% to 3%

The change will likely come in two phases:

First, the market will become comfortable with inflation settling above 2%. This is likely a 2024-25 phenomenon.
Then, when the unemployment rate is high enough, and with enough political pressure, the Fed will officially increase its target to 3%, ultimately paving the way for it to resume QE and lower interest rates. This is likely a 2025-26 phenomenon.

That’s a wrap!

If you found this blog post helpful:

Go to www.42macro.com to unlock actionable, hedge-fund-caliber investment insights.
RT this thread and follow @42Macro and @42MacroWeather.
Have a great day!

All Things Macro

Darius recently sat down with Nick Halaris to discuss proper risk management, the labor market, inflation, asset markets, and much more.

If you missed the interview, here are three takeaways from the conversation that have significant implications for your portfolio:

1. Investors Are Doing A Great Disservice To Themselves By Not Being Bayesian

At 42 Macro, we use three core tenants to form our systematic macro risk management process:

Regime Segmentation: We identify which investable regime the economy is in, the probability of that regime persisting, and how long it is likely to persist.
Bayesian Inference: We systematically update the probability of relevant economic scenarios as new information becomes available to the market.
Risk Management Tools: We use sophisticated quantitative tools like our Volatility Adjusted Momentum Signal (VAMS) and Global Macro Risk Matrix to predict when the price momentum of a particular security or overall market regime (risk on vs. risk off) is likely to change.

We urge our readers to infuse proper risk management in their investment strategies. We welcome you to use our tools if you want to gain a systematic edge in the market: https://42macro.com/sampleresearch.

2. Labor Hoarding Has Contributed To The Resilience Of The US Economy

The most recent US Total Labor Force SA reading was 167 million people – a value below its trendline since 2009.

Conversely, Gross Domestic Income recovered its trendline approximately 18 months ago and remains above it.

The discrepancy in strength between the two indicators suggests there is a large amount of cash in the economy that can be used to demand goods and services but insufficient labor to supply those goods and services.

3. History Tells Us The Fed Must Break The Economy to Achieve Its Price Stability Mandate

We analyzed every recession since 1969 and found that, on a median basis, core PCE inflation is almost always flat-to-up in the year leading up to a recession.

Historically, inflation does not break down without a recession.

Both this study and our HOPE+I framework confirm that inflation is a lagging indicator, and we believe it will again fail to fall below the Fed’s 2% target without a recession.

That’s a wrap!

If you found this blog post helpful:

Go to www.42macro.com to unlock actionable, hedge-fund-caliber investment insights.
RT this thread and follow @42Macro and @42MacroWeather.
Have a great day!